Sole Trader to Ltd - Director's loans
Discussion
Hi,
My wife is looking to move from sole trader status to a limited company. She is a freelance writer with three lareg contracts and a handful of small ad-hoc ones
The plan being to pay a small salary and dividends etc. from a tax efficiency perspective
I need to check my understanding regards Director's loan accounts.
Can they be used as a mechanism to maintain steady income?
Currently as a sole trader she can 'draw' income on a monthly basis as long as money for future tax is earmarked. Waiting a year for the full dividend of profits however will not be practical.
So, allowing for my over simplifying, can you basically take money from the company via the loan account on a regular basis as long as you stay in line with expected dividends at y/e and then reconcile everything in the company accounts?
Many thanks.
Chris
My wife is looking to move from sole trader status to a limited company. She is a freelance writer with three lareg contracts and a handful of small ad-hoc ones
The plan being to pay a small salary and dividends etc. from a tax efficiency perspective
I need to check my understanding regards Director's loan accounts.
Can they be used as a mechanism to maintain steady income?
Currently as a sole trader she can 'draw' income on a monthly basis as long as money for future tax is earmarked. Waiting a year for the full dividend of profits however will not be practical.
So, allowing for my over simplifying, can you basically take money from the company via the loan account on a regular basis as long as you stay in line with expected dividends at y/e and then reconcile everything in the company accounts?
Many thanks.
Chris
Strictly speaking, no.
With a sole trader, "Drawings" by the proprietor are completely ignored when calculating the proprietor's tax (and Class 4 NI) liability. The proprietor is taxed purely on the profit of the business BEFORE any personal drawings are extracted.
For example, if a sole trader business has a profit of £50,000 and the proprietor draws out £40,000, they are taxed on the £50,000. If they drew out £60,000, they would still be taxed on the £50,000.
It's very different with a limited company.
The COMPANY pays Corporation Tax on its profits.
The proprietor (shareholder/director) pays Income Tax (and sometimes NI) on what they extract personally from the company.
The company profits are calculated in a broadly similar way to that of a sole trader. However, if the proprietor withdraws money from the business by way of a salary, then the company profits on which the Corporation Tax is payable will be the profits AFTER the salary has been deducted. This is because salary/ wages are allowable business costs (unlike Drawings for a sole trader).
Obviously, if salaries are being paid, PAYE and NI might need to be paid depending on the salary levels.
The proprietor (as a shareholder rather than a director) can also withdraw cash from the company in the form of dividends. Dividends are regarded as "distributions of profits after Corporation Tax) so are NOT regarded as allowable business costs.
Dividends are only subject to Income Tax IF the person withdrawing the dividend has enough income in the tax year that would put him/her into the Higher Rate tax band.
Dividends are NOT subject to NI. This is because they are regarded as "Investment Income" and not "Earned Income". NI is only chargeable on earned income.
Using a directors loan account as a cash pot is not really advisable. HMRC do not like this and they have a number of provisions in the tax rules in order to discourage directors from using their directors loan account in this manner.
Firstly, there could be a PAYE Benefit in Kind charge arising. This is based on
a) the loan exceeding £10,000 at any point in the year
b) the director being charged no or low interest by the company
HMRC also have penalty rules for failing to clear a director's loan account within 9 months of the end of the financial year.
There are no problems if a director's loan account is the other way around i.e. the company owes money to the director.
There are also Companies Act disclosure requirements in respect of director's loan accounts - especially if the money is owed by the director back to the company.
Hope that helps.
With a sole trader, "Drawings" by the proprietor are completely ignored when calculating the proprietor's tax (and Class 4 NI) liability. The proprietor is taxed purely on the profit of the business BEFORE any personal drawings are extracted.
For example, if a sole trader business has a profit of £50,000 and the proprietor draws out £40,000, they are taxed on the £50,000. If they drew out £60,000, they would still be taxed on the £50,000.
It's very different with a limited company.
The COMPANY pays Corporation Tax on its profits.
The proprietor (shareholder/director) pays Income Tax (and sometimes NI) on what they extract personally from the company.
The company profits are calculated in a broadly similar way to that of a sole trader. However, if the proprietor withdraws money from the business by way of a salary, then the company profits on which the Corporation Tax is payable will be the profits AFTER the salary has been deducted. This is because salary/ wages are allowable business costs (unlike Drawings for a sole trader).
Obviously, if salaries are being paid, PAYE and NI might need to be paid depending on the salary levels.
The proprietor (as a shareholder rather than a director) can also withdraw cash from the company in the form of dividends. Dividends are regarded as "distributions of profits after Corporation Tax) so are NOT regarded as allowable business costs.
Dividends are only subject to Income Tax IF the person withdrawing the dividend has enough income in the tax year that would put him/her into the Higher Rate tax band.
Dividends are NOT subject to NI. This is because they are regarded as "Investment Income" and not "Earned Income". NI is only chargeable on earned income.
Using a directors loan account as a cash pot is not really advisable. HMRC do not like this and they have a number of provisions in the tax rules in order to discourage directors from using their directors loan account in this manner.
Firstly, there could be a PAYE Benefit in Kind charge arising. This is based on
a) the loan exceeding £10,000 at any point in the year
b) the director being charged no or low interest by the company
HMRC also have penalty rules for failing to clear a director's loan account within 9 months of the end of the financial year.
There are no problems if a director's loan account is the other way around i.e. the company owes money to the director.
There are also Companies Act disclosure requirements in respect of director's loan accounts - especially if the money is owed by the director back to the company.
Hope that helps.
It's great having Eric on board giving such comprehensive answers. I took out an interest free director's loan in excess of £10000 for the first time last year but paid it off by way of dividends before the 9 months was up and do expect some additional BIK tax.
I would only do this if I was 100% sure that it could be paid off in order to avoid the "corporation tax" owed if you fail to pay it off within the 9 months.
I would only do this if I was 100% sure that it could be paid off in order to avoid the "corporation tax" owed if you fail to pay it off within the 9 months.
Dividends can be paid more frequently than once a year. Large PLCs often issue dividends at six month intervals i.e. an Interim Dividend followed by a Final Dividend.
That still may be a bit too much of a time gap for a small owner managed company. However, HMRC are rather wary of those who draw down dividends TOO frequently - such as at monthly intervals. If they see what are claimed to be dividends being paid out monthly, they may be able to assert that the payments are actually "salary" and therefore they could then ask for the missing PAYE and NI.
I think quarterly dividends are a better compromise.
Dividends should always be supported by the following documentation -
i) minutes of a directors meeting where the dividend amount was decided on
ii) some form of accounts on which the dividend was based. Dividends can only be paid out of available reserves. HMRC would expect to be able to see (if they asked) what management information was relied upon to justify the dividend payments
iii) a dividend voucher for each dividend payment to each individual shareholder receiving the dividend
That still may be a bit too much of a time gap for a small owner managed company. However, HMRC are rather wary of those who draw down dividends TOO frequently - such as at monthly intervals. If they see what are claimed to be dividends being paid out monthly, they may be able to assert that the payments are actually "salary" and therefore they could then ask for the missing PAYE and NI.
I think quarterly dividends are a better compromise.
Dividends should always be supported by the following documentation -
i) minutes of a directors meeting where the dividend amount was decided on
ii) some form of accounts on which the dividend was based. Dividends can only be paid out of available reserves. HMRC would expect to be able to see (if they asked) what management information was relied upon to justify the dividend payments
iii) a dividend voucher for each dividend payment to each individual shareholder receiving the dividend
cmc68 said:
Thanks for the replies.
So if she moves from sole to limited, is ther anither way to release 'dividends' or profit more reglularly than at year end?
SHe isn' t in the position to hold of the income for a year,
Thanks.
Chris
As Eric says. Quarterly. I do know of others doing monthly but I wouldn't be comfortable about doing so. My accountant advised no more frequently than quarterly. It's simple but just requires a bit better budgeting with personal finances. So if she moves from sole to limited, is ther anither way to release 'dividends' or profit more reglularly than at year end?
SHe isn' t in the position to hold of the income for a year,
Thanks.
Chris
Sorry I have to disagree entirely with the frequency of dividends. Find me a case where monthly dividends have been challenged... Or find me an accountant advising that they have been challenged during an enquiry. The only issue is paperwork. If HMRC felt they could attack it, they would have by now.
We pay them monthly, based on last year's nett profits. Our accountants are happy with it.
We tend not to pay ourselves a huge amount though; if there's a decent profit from the previous year, we transfer some of it over to the director loan accounts as dividends given back to the company in the form of loans, although it's just a paperwork exercise. This lets us take them in years following a poor profit, where we wouldn't have enough profit to pay the usual dividend.
As said, our accountants haven't said we should't do this, I just followed the guidelines that dividends can be taken up to the higher rate of tax threshold without incurring income tax. This includes the amount, if any, we transfer into the loan accounts.
We tend not to pay ourselves a huge amount though; if there's a decent profit from the previous year, we transfer some of it over to the director loan accounts as dividends given back to the company in the form of loans, although it's just a paperwork exercise. This lets us take them in years following a poor profit, where we wouldn't have enough profit to pay the usual dividend.
As said, our accountants haven't said we should't do this, I just followed the guidelines that dividends can be taken up to the higher rate of tax threshold without incurring income tax. This includes the amount, if any, we transfer into the loan accounts.
cmc68 said:
Thanks for the replies.
So if she moves from sole to limited, is ther anither way to release 'dividends' or profit more reglularly than at year end?
SHe isn' t in the position to hold of the income for a year,
Thanks.
Chris
You can pay dividends daily if you want, perfectly legal if your paperwork is correct. I mean, you wouldn't, but you could.So if she moves from sole to limited, is ther anither way to release 'dividends' or profit more reglularly than at year end?
SHe isn' t in the position to hold of the income for a year,
Thanks.
Chris
MaxFromage said:
Sorry I have to disagree entirely with the frequency of dividends. Find me a case where monthly dividends have been challenged... Or find me an accountant advising that they have been challenged during an enquiry. The only issue is paperwork. If HMRC felt they could attack it, they would have by now.
We too were advised not to pay the same amount of dividend on a monthly basis.Super Slo Mo said:
We pay them monthly, based on last year's nett profits. Our accountants are happy with it.
We tend not to pay ourselves a huge amount though; if there's a decent profit from the previous year, we transfer some of it over to the director loan accounts as dividends given back to the company in the form of loans, although it's just a paperwork exercise. This lets us take them in years following a poor profit, where we wouldn't have enough profit to pay the usual dividend.
As said, our accountants haven't said we should't do this, I just followed the guidelines that dividends can be taken up to the higher rate of tax threshold without incurring income tax. This includes the amount, if any, we transfer into the loan accounts.
Why based on last year's net profit? Is it not possible to pay YTD up to last month as long as the P&L can be calculated accurately to the satisfaction of the directors?We tend not to pay ourselves a huge amount though; if there's a decent profit from the previous year, we transfer some of it over to the director loan accounts as dividends given back to the company in the form of loans, although it's just a paperwork exercise. This lets us take them in years following a poor profit, where we wouldn't have enough profit to pay the usual dividend.
As said, our accountants haven't said we should't do this, I just followed the guidelines that dividends can be taken up to the higher rate of tax threshold without incurring income tax. This includes the amount, if any, we transfer into the loan accounts.
RegMolehusband said:
Why based on last year's net profit? Is it not possible to pay YTD up to last month as long as the P&L can be calculated accurately to the satisfaction of the directors?
Yes, you can, but I do it that way as it's nice and simple to administer, given that I spend a stupid amount of time on the road, and dealing with the book keeping needs to be kept straightforward at least until I'm solely office based. 
My accountant asked me to swap from monthly dividends to quarterly dividends on the basis that HMRC could argue that monthly was really salary, the latter subject to NI.
It didn't cause me any inconvenience so better safe than sorry I say.
Remember, HMRC staff are paid to argue the toss with you, you aren't with them!
It didn't cause me any inconvenience so better safe than sorry I say.
Remember, HMRC staff are paid to argue the toss with you, you aren't with them!
Everything I have read or heard at numerous tax lectures over the years has pointed to the dangers of paying dividends too frequently. However, there is no specific legislation that dictates when dividends can or cannot be paid.
HMRC have the powers to interpret payments based on their view on what they represent. The only factor that stops them from tackling frequent "dividend" payments is lack of resources at their end.
So, if you want to pay monthly dividends, go ahead and do so. But do be aware that there is an element of risk attached to that strategy - especially if all the other underlying supporting "dividend decision" paperwork is not maintained.
Basing how you apply tax regulations on the mantra that "HMRC have never caused me a problem" is a flawed approach. It could just mean that, so far, you have been lucky.
HMRC have the powers to interpret payments based on their view on what they represent. The only factor that stops them from tackling frequent "dividend" payments is lack of resources at their end.
So, if you want to pay monthly dividends, go ahead and do so. But do be aware that there is an element of risk attached to that strategy - especially if all the other underlying supporting "dividend decision" paperwork is not maintained.
Basing how you apply tax regulations on the mantra that "HMRC have never caused me a problem" is a flawed approach. It could just mean that, so far, you have been lucky.
Quarterly works well with my clients. Usually, we prepare VAT returns, reconcile everything to a set of management accounts and then declare dividends based on current reserves.
I'm happy, as I know how my clients are performing, they're happy as everything is done in a timely fashion and they get some cash. Sometimes we pay everything through the loan account, but I'd rather keep well above board.
I'm happy, as I know how my clients are performing, they're happy as everything is done in a timely fashion and they get some cash. Sometimes we pay everything through the loan account, but I'd rather keep well above board.
There are quite detailed disclosure requirements on Directors' Loan Account (DLA) transactions embodied in the 2006 Companies Act. These provisions were included in the legislation following pressure from HMRC. They want businesses to self declare how the director loan accounts within a company are being used.
What they don't like is a company using the DLA as a kind of pot which is then "fixed" by the making of a dividend provision. We all know this is often how DLAs are managed, especially in small companies, but it is not really correct and HMRC have the absolute right to deem that periodic withdrawals from a company by a director to be treated as salary amounts - no matter what the director or his accountant planned to do regarding their treatment.
The disclosure requirements now incorporated in company law are there to provide HMRC with a window through which they can see how the DLA is being managed. Whether that is happening in practice is another matter.
What they don't like is a company using the DLA as a kind of pot which is then "fixed" by the making of a dividend provision. We all know this is often how DLAs are managed, especially in small companies, but it is not really correct and HMRC have the absolute right to deem that periodic withdrawals from a company by a director to be treated as salary amounts - no matter what the director or his accountant planned to do regarding their treatment.
The disclosure requirements now incorporated in company law are there to provide HMRC with a window through which they can see how the DLA is being managed. Whether that is happening in practice is another matter.
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